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Tuesday, December 30, 2014

The largest and most dangerous misconception in the financial world today is that central banks have the ability to control the direction of markets. History has show with clear distinction this is not the case, but investor's minds continuously experience the "recency bias."

During gold's most recent cyclical bull rally (2008 to 2011) analysts put up a chart of the price of gold layered against the the Fed's balance sheet growth. They tracked with each other for three straight years, which made investors feel that gold's rally would always track side by side with the Fed's balance sheet.

We know now this did not occur as the Fed continued expanding its balance sheet through QE3 while gold experienced its second major cyclical decline of the current secular bull market. While the Fed's balance sheet impacts the fundamentals for gold's price direction, it cannot be used as direct causation for the short term movement in its price.

To understand why we'll look a little further back in history. Gold bottomed in early 2001 at $250 and rose to $900 in 2008 during a period when the Fed was mostly raising interest rates and tightening monetary policy (2004 - 2007).

Since the arrival of QE in early 2009 analysts have been tracking the S&P 500 against the Fed's balance sheet. This has once again created the myth that the Fed pushes U.S. stocks higher and guides them lower.

This myth has already proven itself to be untrue as the Fed began tapering (slowing reducing the size) of QE in late 2013 and ended the program in October 2014. Stocks have risen steadily throughout this process and are currently sitting at all time record highs as I type this morning.

Even with this recent evidence available that stocks have already diverged from the Fed, investors cling to the notion that if the stock market begins to fall the Fed will step in with a new QE program and instantly reverse the price decline. As I said at the outset, this belief is the most dangerous assumption that permeates within the minds of investors today.

Because we are currently sitting at 0.0% interest rates the only possible way for the Fed to ease is with QE, which can be thought of as bringing rates to negative levels. The size of QE programs has become the new Fed fund rates in the perverse financial world we live in today.

So the question is, if U.S. stocks were to fall (which most people believe is now impossible to begin with), and the Fed were to begin lowering rates downward into negative territory (using QE), would they be able to instantly stop a market decline? Let's take a quick walk through history....

The 1920's run in stock prices peaked at the very end of 1929. When the market began to roll over and decline the Fed began cutting rates on February 11, 1930. The market would then go on to decline by 90% over the next two years through the rate cuts.

When the market peaked in 2000 after the greatest run in market history from 1980 to 2000, the Fed began cutting rates a few months later on January 3, 2001. The NASDAQ would go on to decline 80% from its peak through the rate cuts.

The Fed began cutting interest rates on September 18, 2007, two months before the U.S. stock market would hit its all time high. They would continue cutting rates for the next two years, bringing them all the way down to 0%. During that time the market declined by over 50% through the rate cuts.

Correlation equals causation only when charts line up for a brief period in history. The human mind acts as a problem solving machine that always looks for the simplest and fastest possible answer to any problem that presents itself so it can move on and begin solving the next one. The mantra that the Fed will always step in to save the markets solves this problem in investor's mind. They can comfortable put their life savings into U.S. stock index funds and move on to something else in their life.

In the past I have compared the psychological state of mind of investors living in Japan (recently experienced a 25 year decline in stock prices) to investors living in the United States (recently experienced the greatest 33 year rise in history and currently sitting at all time highs).

I live in the United States so I can live, breath and take in the almost religious belief that stocks will always move higher in the long run. Americans leave school and then put their hard earned money into U.S. stock 401ks for the duration of their entire working years. Everyone around them does it, the media and government tell them to do it, financial advisors tell them to do it, and it has worked brilliantly for as long as almost any American has been working in the United States (no one remembers the 1970's today).

If you showed the chart below to an average American and told them it was anything except for U.S. stocks, they would be most likely terrified of the future price potential of the asset. If you showed this chart to a Japanese citizen you would probably make them cry if you asked them enter the market with a portion of their savings. It would appear, even to the most casual viewer, we are in the final stages of the third bubble in the last 15 years (this chart is dated, the S&P has rocked up to 2090 as I write this morning)

Investors understand and believe the previous two bubbles and crashes were driven by overly accommodative Fed policy. However, after 5 years of the most accomodative monetary policy in Federal Reserve history, with stocks sitting at all time record high prices, and almost every valuation metric resting at all time record high levels, investors believe this time is different.

I'm betting that this time is not different, and I'm willing to wait for as long as it takes for prices to move back into realistic historical valuations before entering. There are just too many other cheap investment opportunities around the world to invest in. If you live in the United States, take a moment to review your portfolio before entering the new year. If U.S. stock funds are your largest investment, you are sitting in the most expensive asset class on the planet.

Monday, December 29, 2014

Many of the economists and financial analysts I read regularly and respect are predicting a major move higher in the U.S. dollar through 2015 and beyond. The fundamentals behind their reasons include the Federal Reserve tightening monetary policy compared to other major central banks simultaneously loosening and the overall strength of the U.S. economy relative to the rest of the world.

These both make sense, and I agree that the U.S. dollar should rise based on these fundamentals against some of the major currencies around the world such as the Japanese yen and the Euro. The problem I have with this in the short term is price and sentiment. The U.S. dollar has already strengthened significantly against the Japanese yen and Euro over the past two years and it appears to be a completely one sided trade at the moment.

In regards to many of the emerging market currencies you can add another piece against this argument: fundamentals. The U.S. currency is fundamentally flawed based on the United States economy's dependence on debt growth for.....everything. Just as with Japan, but in a far less extreme case, if interest rates were to begin to move higher in any sort of meaningful way it would expose an enormous layer of malinvestment spread across the U.S. economy. Emerging markets already have high interest rates, most at double digits and higher.

The second and third arguments against dollar strength against EM currencies are price and sentiment. In the chart below you can see emerging market currencies are now below their 2008 and 2002 lows against the U.S. dollar. While there are reasons why investors could continue to pull money out in the years ahead (hot money reversals from the Fed's easy monetary policy, China's slowdown, flight to safety, etc.), how much of that has already been baked into the cake?

Sentiment is almost as one sided with emerging market currencies (complete love fest for the U.S. dollar and hatred for EM currencies) as it is for the developed countries such as Japan.

I understand all the reasons why the Brazilian real and Indian Rupee can fall against the U.S. dollar moving forward, but how much of that has been priced in with the currencies declining to new 15 year lows? Based on price and sentiment I am neutral or slightly bullish on the short term direction of these currencies and extremely bullish on their long term potential. I am beginning to slowly add to positions now. My hope, as always, is panic will enter the markets and push them into further oversold territory. For a perfect example of that, see what occurred with the Russian Ruble earlier this month.

Wednesday, December 24, 2014

In a normal economic times falling energy costs would be considered unadulterated good news. The facts are simple. No one buys a barrel of oil to display above the mantle. No one derives happiness from a lump of coal. Energy is simply a means to do or get the things that we want. We use it to stay warm, to move from Point A to Point B, to transport our goods, to cook our food, and to power our homes, factories, theaters, offices, and stadiums. If we could do all these things without energy, we would happily never drill a well or build a windmill. The lower the cost of energy, the cheaper and more abundant all the things we want become.

This is not economics, it is basic common sense. But these are not normal economic times, and the mathematics, at least for the United States, have become more complicated.

Most economists agree that the bright spot for the U.S. over the past few years has been the surge in energy production, which some have even called the "American Energy Revolution". The stunning improvements in drilling and recovery technologies has led to a dramatic 45% increase in U.S. energy production since 2007, according to the International Energy Agency (IEA). And while some suggest that the change was motivated by our lingering frustration over foreign energy dependence, it really comes down to dollars and cents. The dramatic increase in the price of oil over the last seven or eight years, completely changed the investment dynamics of the domestic industry and made profitable many types of formerly unappealing drilling sites, thereby increasing job creation in the industry. What's more, the jobs created by the boom were generally high paying and full time, thereby bucking the broader employment trend of low paying part time work.

The big question that most investors and drillers should have been asking, but never really did, was why oil rocketed up from $20 a barrel in 2001 to more than $150 barrel in 2007, before stabilizing at around $100 a barrel for much of the past five years. Was oil five times more needed in 2012 than it was in 2002? See my commentary here for more on that subject.

Despite the analysts' recent discovery of a largely mythical supply/demand imbalance, the numbers do not explain the rapid and dramatic decrease in price. Yes, supply is up, but so is demand. And these trends have been ongoing for quite some time, so why the sudden sell off now? Instead, I believe that oil prices over the last decade has been driven by the same monetary dynamics that pushed up the prices of other commodities, like gold, or of financial assets, such as stocks, bonds, and real estate. I believe that oil headed higher because the Fed was printing money, and everyone thought that the Fed would keep printing. But now we have reached a point where the majority of analysts believe that the era of easy money is coming to an end. And while I do not believe that we are about to turn that monetary page, my view is decidedly in the minority. Could it be a coincidence that oil started falling when the mass of analysts came to believe the Fed would finally tighten?

If I am wrong and the Fed actually begins a sustained increase in rates starting in 2015, oil prices may very well stay low for a long time. But apart from the fact that our broad economy can't tolerate higher interest rates, an extended drop in oil prices may create conditions that further force the Fed's hand to reverse course.

If prices stay low for very long, many of the domestic drilling projects that have been undertaken over the past few years could become unprofitable, and plans for further investment into the sector would be shelved. Evidence suggests that this is already happening. Reuters recently reported a drop of almost 40 percent in new well permits issued across the United States in November (this was before the major oil price drops seen in December).

This huge negative impact on the primary growth driver of U.S. economy may be enough in the short-run to overwhelm the other long-term benefits that cheap energy offers. If prices stabilize at current levels, then the era of triple digit oil may, in retrospect, be looked back on as just another imploded bubble. And like the other burst bubbles in tech stocks and real estate, its demise will make a major impact on the broader economy. But there is a crucial difference this time around.

When the dot-com companies flamed out in 2000, most of the losses were seen in the equity markets. Dot-coms either raised money either through venture capitalists or the stock markets. They rarely issued debt. The trillions of dollars of notional shareholder value wiped out by the Nasdaq crash had been largely paper wealth that had been created by the sharp run up in the prior two years. As a result, the damage was primarily contained to the investor class and to the relatively few number of highly paid tech workers and entrepreneurs that rode the boom up and then rode it down. In any event, the Fed was able to cushion the blow of the ensuing recession by dropping rates from 6% all the way down to 1%.

The real estate and credit crash of 2008 was a much different animal. Despite the benefits that lower home prices may have brought to many would be home-buyers who had been priced out of an overheated market, the losses generated by defaulting mortgages quickly pushed lending institutions into insolvency and threatened a complete collapse of the U.S. financial system. Unlike the dot-com crash, the bursting of the housing bubble posed an existential threat to the country. The construction workers, mortgage brokers, landscapers, real estate agents, and loan officers who were displaced by the bust represented a significant portion of the economy. To prevent the bubble from fully deflating, the Fed bought hundreds of billions of toxic sub-prime debt (that no one else would touch) and dropped interest rates from 5% all the way down to zero.

I believe, a bust in the oil industry will likely play out somewhere between these two prior episodes. As was the case with falling house prices, while low prices offer benefits to consumers, the credit and job losses related to unwinding the malinvestments, made by those who believed prices would not drop, can impose severe short-term problems that the Fed will be unwilling to tolerate. Of course, long-term it's always good when a bubble pops, it's just that politicians and bankers are never prepare to endure the short-term pain necessary for long-term gain when they do.

A good portion of the money used to finance the fracking boom was raised by relatively small drillers in the debt market from banks, institutional investors, pension funds, hedge funds, and high net worth wildcatters. Public involvement has been involved primarily in the high yield debt market where energy companies have issued hundreds of billions of "junk" bonds in recent years. In 2010, energy and materials companies made up just 18% of the US high-yield index but today they account for 29%.

But many of the financing projections that these bond investors assumed will fall apart if oil stays below $60. Although the junk bond market is nowhere near as large as the home mortgage market, widespread defaults from energy-related debt could cause a crisis, which could make wider ripples throughout the financial edifice. Bernstein estimates that sustained $50 oil could result in investment in the sector to fall by as much as 75%. According to the Department of Labor, oil and gas workers as a percentage of the total labor force has doubled over the past decade, and have accounted for a very large portion of the high-paying jobs created during the current "recovery." As a result a bust in the oil patch will result in a very big hit to American labor, causing ripple effects throughout the economy.

But we are far less able to deal with the fallout now of another burst bubble than we were in 1999 or 2007 (the years before the two prior crashes). I believe it will take much less of a shock to tip us into recession. But I don't even believe that a burst energy bubble is even our biggest worry. Much greater and more fragile bubbles likely exist in the stock, bond and real estate markets, which have also been inflated by the easiest monetary policy in history. More importantly at present the Fed lacks the firepower to fight a new recession that a bursting of any of these bubbles could create.Since interest rates are already at zero, it has no ability to aggressively cut rates now in the face of a weakening economy. All it can do is go back to the well of quantitative easing, which is exactly what I think they will do.

Despite the widely held belief that 2015 will be the year in which a patient Fed finally begins to normalize rate policy, I believe the Fed has no possibility of withdrawing the stimulus to which it has addicted us. QE4 was always much more probable than anyone in government or on Wall Street cares to admit. A recession and a financial panic caused by sub $60 oil will significantly quicken the timetable by which the Fed cranks up the presses. When it does, oil could once again increase in price, along with all the other things we need on a daily basis. That should finally dispel any remaining illusions that the Fed could successfully land the metaphorical plane. More QE may minimize the damage in the short-term, but I believe it will keep us trapped in our current cocoon of endless stimulus, where we will slowly suffocate to death.

Tuesday, December 23, 2014

Robert Shiller's first edition of Irrational Exuberance was released in March of 2000, the exact month the NASDAQ peaked and then fell 80%. The book was focused on the irrational exuberance surrounding U.S. stocks at that time.

In the summer of 2005 the second edition of the book was released, which focused on U.S. residential housing. That summer marked the peak in price for many markets in the United States, which then collapsed in the years ahead.

In an interview he gave this week Shiller told ETF.com that he is currently writing the third edition to his book. Here are his comments (for the full interview click here).

This is probably a question you're getting a lot lately: Are we in a period of irrational exuberance right now?

I'm actually working on the third edition of my book, "Irrational Exuberance." Anyway, it's a matter of degree—it's a matter of percentages. The market has been going up rapidly and there is some exuberance behind that, I suppose. But it's not something that is uniform. There is a story at any time, and the story has multiple dimensions.

One thing that our story now is starting to share in common with the year 2000, which was the peak of the market in real terms—the 2007 peak didn't make it back up to that level, so I think of 2000 as a major turning point—is at that time, people were very concerned that the market was overpriced. We have been seeing increased concerns that that would happen; that is a sign of a bubble. If you're buying and holding the market but think it's overpriced, that might be a sign of irrational exuberance.

What is irrational exuberance? I think it's often a sense that the market always goes up in the long run, and it's hard to predict when it might go down, but it will surely come back up. So one question I have been asking in surveys is, "Do you agree with the following statement: The stock market is the best investment for long-term holders who can just buy and hold through the ups and downs of the market." Our agreement with that is going up, but it's not as high as it was in 2000. We're not quite in a 2000-like irrational exuberance, but we're moving in that direction.

Monday, December 22, 2014

These totals follow 33 years of rising bond prices and 5 spectacular years of stock market gains (most portfolios are concentrated within U.S. stock and bond funds).

I don't want to sound like an alarmist, but there are probably a lot of very worried people out there right? No one could reasonably expect to support themselves for 20 years or more in retirement on $126,900 in 401k savings.

Remember when you enter retirement you must begin to sell your 401k in order to pay for your living expenses. When you sell you incur the income taxes you did not paying going into the program.

Here is the bigger problem: What if a baby boomer is financially astute enough to understand the U.S. stock and bond markets are both close to the climax of historical bubbles with tremendous principle losses around the corner?

Here is the alternative return they could receive by exiting the markets and depositing $100,000 in a bank CD (cash). From a $5,240 return in 2006 they now receive $390 annually. Enough to pay their car payments for a month.

This is the dilemma facing retirees today, dubbed financial repression. Do you walk out on the plank to try and reach for yield, understanding that the board could snap at any moment? Or do you patiently sit in cash while inflation eats away at your life savings?

The Fed's QE program is a wealth transfer mechanism. About $400 billion every year that banks would have to pay out to American savers in interest is kept in their pockets with interest rates held at 0%.

“I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern shipbuilding has gone beyond that.”

- Edward Smith, Captain, RMS Titanic

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”

Sunday, December 21, 2014

I'm someone that spends an unhealthy amount of time focused on business and investing. I've discussed in the past that when I'm not directly working on a business activity or studying finance, I'm often thinking or daydreaming about it indirectly.

Something I've noticed throughout the years that has both fascinated and surprised me is that great business owners tend to be mediocre or poor investors and great investors tend to be mediocre or poor business owners. The relationship exists on somewhat of a sliding scale. I'll give you an example I have experienced personally.

Throughout 2013 and a good part of 2014 I worked with one of the largest commercial real estate finance companies in the United States. I spent my days pouring through and analyzing loans on large real estate projects.

In my office and other offices around the country I had the opportunity to interact with some of the most brilliant minds in commercial real estate finance. With their decades of experience they were able to show me things about a potential building, market, or investor that I could not initially see when I read through the documents.

A commercial building is a business that exists within an economic ecosystem. You can look at population growth, business activity and an endless amount of data that would impact supply and demand surrounding the building. This then directly impacts rent levels and vacancy, which determine both the building's value and ability to pay back the loan.

Here is where business met finance for those that don't love real estate: Part of making a loan involves setting a loan value that can still perform should interest rates rise in the future. For example, if you make a loan today at 4% interest, you want the building to have the ability to still generate enough income to pay the loan at 7% interest in the future (the loan will need to be refinanced, the owner could get into financial trouble, etc.).

I found my coworkers could create flawless models showing how this risk could be minimized, however, in conversations I had with them privately almost no one could provide me a financial explanation to why rates could or would rise in the future. They essentially did not pay attention, or did not understand, what would push rates in either direction moving forward.

Many of these people had been working in the commercial finance industry for decades leading up to the summer of 2008. Countless people I spoke with told me that they watched their portfolios disappear almost overnight following that summer as their company stock (which they loaded up heavily on during the boom years) was wiped away in an instant. No one told me they had a "bad feeling" about the market and decided to cash in some of their profits, andthese are the people that were on the front lines of commercial real estate finance!

How could that be?

A different part of the human brain is used to make business decisions than the part used to make financial decisions. The business/rational/economic part of the brain is called the Neocortex, which is the part dedicated to maximizing utility. People strong in this area have the ability to build great businesses or determine value within a commercial building based on the surrounding economic supply and demand factors in the market.

Price, supply and demand are all very important within the Neocortex. Remember the black Friday videos released a few weeks ago where consumers were trampling each other and fighting to purchase TV's at Walmart? That is the Neocortex at work, the part of the brain that tells someone to buy something because the price is lower.

A second part of the brain called the Limbic System deals with the financial markets. It is emotion driven and it is what causes investors to engage in herding behavior. Investors want to own an asset more when prices rise and they want to own an asset less when prices fall. I could spend hours with countless charts showing this phenomenon in work, and long time readers have seen many of these examples over the years.

Investors in the financial markets naturally move in herds, they are emotion driven and logic goes almost completely out the window. This is not because they are unintelligent; it is just the way that humans are wired psychologically. Unless you spend a ridiculous amount of time studying market history (and strengthening your Limbic System), the natural tendency based on your everyday surroundings will be to enter this psychological herd.

The best example of this in nature is the murmuration of starlings. There can be no better visual of how investors exist within the financial world than the video below:

This is why great business people tend to be poor investors. If you spend a tremendous amount of time strengthening the Neocortex part of your brain (where supply and demand are important to business decisions), then it will most likely come at the expense of your Limbic System (in the financial markets supply and demand have an almost inverse corollary).

Consumers and businesses make rational decisions within a healthy economic ecosystem:

While in the stock market, for example, the exact opposite occurs. Higher prices lead to higher demand due to the natural herding psychology of humans surrounding financial decisions. Everyone wants to own stocks at the top, and no one wants them at the bottom.

I don't want to say this in a way that sounds mean (I certainly do not consider myself a highly intelligent person), but I have found entering a discussion with someone on finance even if (or especially if) it is someone who is an accomplished business person, is a complete waste of time (and borderline detrimental). I like to talk to great business people about business, and I try to focus conversations surrounding finance with people who have a profession that exists within that world (they are forced to strengthen their Limbic System daily). For this reason almost no one in my personal or business life knows that I am a financial nerd. I would rather talk to them about sports or catch up on their personal lives.

There are a few people out there I have spotted that can comfortably exist in both worlds. One of them is Mark Cuban, the owner of the Dallas Mavericks professional basketball team in the United States. He is a billionaire who has created countless profitable companies over the past 15 years. His Neocortex is extremely strong.

However, he also has the ability to shift gears and walk on to the CNBC studio (America's largest financial television network) and carry on a fluent conversation surrounding finance. In late 2012 he took all of his business debt and converted it from U.S. dollars to Japanese yen. The yen was trading at 77 at the time and has now fallen to 119, meaning he has paid off 35% of all his debt with a simple keystroke. Based on what he has told others, he has spent countless hours over the past 25 years strengthening both areas of his brain (he was not born with some sort of gift). He is a complete workaholic.

While my business and investment world still exists with far less zeros than Cuban's, the concepts are essentially the same. My goal is to continue to strengthen both portions of my brain daily to be better prepared for both the business and financial world as I move forward. I'll be here updating the Limbic System view of the world every step of the way!

Friday, December 19, 2014

I received an email this week from a mortgage lender with the details on Fannie Mae's new 3% down mortgage program. It appears to be targeting first time home buyers (the group of Americans that have been reluctant to join the home buying party since the last crash). The lending restrictions on the program will continue to loosen until we arrive at the next major crash and American tax payers once again have to write a check for hundreds of billions of dollars in losses.

No one pays attention to the cause, but they are always very upset when the effect arrives. Here are the major details of the program:

- 30 year fixed mortgage
- Primary residence only
- At least one of the borrowers must be first time home buyer
- Minimum credit score 640
- 3% down payment (which can be a gift)

A "gift" means that if a young American is purchasing a $300,000 home, they can get the $9,000 (3%) down payment needed from Mom and Dad. So a young American fresh out of college that has found a job and has $65,000 of student loan debt (government financed) can instantly get another $291,000 in mortgage debt (government financed) without having to save a penny. All they need is a $20,000 car loan (government financed) and a nice 0% deferred interest plan on $15,000 to furnish the home and they are officially living the American dream.

$400,000 in total debt (including the $9,000 they owe Mom and Dad) which they can now try to pay down for the rest of their life. The economy grows due to the credit expansion, the rich get richer, and 15 years later that young American wonders why the middle class is running in quicksand while slowly sinking.

Thursday, December 18, 2014

It may surprise many Americans who pay much closer attention to the stock market ticker, but entering the trading day yesterday long term treasury bonds were having their 5th best year in history, up 28.2%.

This return has come mostly through appreciation as bond values rise as interest rates fall. We recently discussed how every financial forecaster polled by Barron's predicted higher stock prices in 2015. What we did not review is that every one of them also predicted lower bond prices (higher yields).

While I think both asset classes are at nosebleed dangerous price levels (I would rather own foreign assets, commodities and cash), sentiment appears to favor owning treasury bonds over U.S. stocks in the new year.

Jim Rickards helps explain to Bloomberg the difference between Russia's corporate and sovereign debt. Where is the corporate debt actually located, meaning who lent to these Russian companies? It was emerging markets and American 401k's, which will feel the impact of the contagion involved with coming defaults (remember how U.S. lenders packaged and sent subprime mortgage time bombs to countries all over the world?).

As he eloquently puts it, "if you want a financial war United States, you have it."

Wednesday, December 17, 2014

Russian markets have been in a panic during the last two days, which I discussed in detail yesterday. Over the past 24 hours we have seen pictures of Russian citizens lining up to exchange their rubles for U.S. dollars.

Russians are not lining up at stores to exchange their rubles for gold, which I find fascinating. Here is how gold has performed over the past two months for any Russian that decided to purchase some insurance on their portfolio in mid November.

It is bizarre to me that the collective public around the world has not yet put the big picture together in a world where financial information is so readily available through the internet. The lines you see of Russians scrambling to exit their currency will soon be replaced with pictures of Japanese citizens in complete terror. Then the panic will eventually spread to another country and then another.

This is not some incredible precognition of the future. It is common sense. Paper currencies have have no intrinsic value, therefore there will always be rolling chaos around the world. One day you wake up and everything is fantastic, and the next day you will wake up to see all your friends in line trying to purchase gold. The global financial system today is far less healthy today than it was entering 2008, with only confidence holding together the mirage by a thread. Confidence evaporates in minutes in a fiat backed monetary system.

Ironically, as I discussed yesterday, Russia's currency is far healthier on paper than the Japanese yen or U.S. dollar. Financial advisors in the United States recommend moving your assets from U.S. stocks back to U.S. bonds in some sort of percentage (like 60% to 40% for example). Your assets are considered "diversified" because U.S. stocks and bonds can "never" fall at the same time. There is no recommendation today to hold a percentage of your assets in cash (foreign or domestic), and there is no recommendation to hold a percentage of your assets in precious metals. Both asset classes are considered truly insane within today's euphoric stock and bond mania. I'm not telling anyone to put 100% of their investments into cash or gold, I'm only saying investors should potentially review a holding of 100% U.S. stocks and bonds.

Over the past 60 days residents of Russia who were "diversified" in Russian stocks and bonds saw a large percentage of their life savings disappear in moments. Now they are running to exchange what is left into U.S. dollars. Over the short term it may be a great move, but over the long term they will soon realize they are only jumping out of the frying pan and into the fire.

Tuesday, December 16, 2014

To say there is full blown panic in the markets surrounding Russia and oil is surely an understatement. While I have been discussing the oil price decline over the past few weeks (oil has now collapsed down to $54), Russia's currency decline has been even more severe over the past year.

The Russian ruble began the year at 33 against the U.S. dollar and fell 13% yesterday alone to finish the day at 66 (then moved past 70 in overnight trading). That is a staggering 53% decline in a single year. The chart below shows the parabolic decline in the Ruble over the past few weeks.

Last night the central bank announced a surprise rate hike of 6.50%, bringing the benchmark interest rate to 17%. This is the sixth rate increase this year.

To help keep the magnitude of this rate increase in perspective, the U.S. currently has rates held at 0.0%. Just imagine the sheer terror that would engulf the U.S. markets if the Fed announced a surprise overnight rate increase of 50 basis points (0.50%). The Russian central bank just increased it by 6.50% overnight!

The Russian ruble and the price of oil are intertwined in this story. Many assume the price of oil falling will completely destroy revenues for oil producers within Russia. However, the currency has fallen further than the price of oil over the past year meaning revenues priced in Russian rubles are essentially flat (or just above) where they were last year.

In 1986, oil fell from over $30 a barrel down to a range of $11 - $13 where it stayed through 1989. This was a large contributor to the fall of the Soviet Union. Many making comparisons to that period today are forgetting the importance of the currency decline mirroring oil's fall. In addition, Russia has far less government debt than they did during that period.

After experiencing a sovereign debt default in 1998 Russia learned the important lesson of holding an enormous foreign reserve war chest, which now sits at $416 billion (after selling $80 billion into the market already this year to defend the ruble).

Here's the best way to explain how this war chest is deployed:

If the Russian ruble begins to fall in the foreign exchange markets, the central bank can enter the markets and sell foreign reserves (the U.S. dollar for example) in exchange for Russian rubles. This has the obvious effect of driving up the value of the ruble (because they are buying it), or stemming its decline. By having this reserve available and promising the markets they are always ready to step in and use it keeps speculators on their toes.

Other countries around the world, such as Brazil, India and China, have also been building these enormous war chests of foreign reserves since the last emerging market crisis in 1998. India was able to stop a mini-crash on the rupee in 2013 following the U.S. Fed taper tantrum.

I will explore my thoughts surrounding the importance of these global reserves in the future (they are part of the reason I am extremely bullish long term on emerging market asset classes), but let's get back to the star of the present; Russia.

The Russian government currently has one of the cleanest balance sheets on the planet. Their current debt to GDP level of only 13.41% looks incredible compared to most sovereign debtors around the world. On top of their foreign reserve savings and abundance of natural resources available to export to the world, Russia has been accumulating gold. While that is unimportant to today's story, it will become extremely relevant following the next major financial collapse when the current monetary system will need to be restructured. Those that come to the table will do so with their gold reserves, and those countries will make the new rules. But again, that is a story for another day.

Russian banks and companies owe nearly $700 billion in external debt, denominated mostly in dollars. With the ruble falling by 50% over the last year, it essentially doubles the burden of paying back this $700 billion. With sanctions put in place by foreign lenders due to Russia's involvement with Ukraine, many of these smaller companies and banks have been shut out of the debt markets. There is about $125 billion of debt that must be rolled over (refinanced) by the end of 2015. Many of these companies have built up foreign cash reserves (similar to the government) to prepare for an event like this happening. Others will have the opportunity to work with the government for help. The rest will be in serious trouble unless the debt markets re-open for them.

The smaller cap Russian companies have seen their stock prices destroyed across the board over the past year. Many are down 80% to 90% with price to earnings ratios now in the low single digits. Investors with b*lls of steel and the ability to determine which companies will successful refinance and survive through this period will experience unbelievable long term profits by taking positions in the market today.

There may be other long term pockets of opportunity in Russia as well.

While the banking and corporate sector of the Russian bond market is murky, we know where the Russian government sits. They owe $38 billion of debt denominated in U.S. dollars, with only $6 billion of interest and principle payments due by the end of 2015. Remember, they currently hold over $400 billion in foreign reserves so they certainly do not need to panic over this $6 billion due in the next year.

A 3 year government bond in Russia currently yields over 18%. That means the government will pay you 18% per year to hold their bonds and at the end of the third year you will receive your principle back. What is the danger of purchasing such a bond? The government could default and you may only receive a portion (or none) of your investment back. Or, if you purchased the bond in Russian currency it could continue to free fall in value over the coming months. If the currency falls by another 50% over the next year, you will feel little excitement over your 18% return (which would only now equal a 9% real return in U.S. dollars with the principle you would receive back at the end of the three years cut in half). With the currency falling by 13% yesterday alone, it is certainly not for the faint of heart.

But what if the currency ever stopped falling? What if oil ever stopped falling? What if the geopolitical tensions loosen just a bit over the coming months or year? The markets are pricing in World War III and a global depression for many Russian assets. That outcome many certainly arrive, but what if it didn't?

Please understand I'm not telling anyone to purchase Russian stocks, bonds or currency which are all in complete free fall. I'm only trying to be a contrarian voice at what could be close to the absolute peak of panic in Russian markets. There are many investors I consider extremely intelligent looking for value in this market at the moment, but it takes a surgeon-like financial skill set to know where to enter and make picks.

Sunday, December 14, 2014

U.S. stock prices will soon enter their sixth year of the current bull market. We are already in the third longest bull market in market history. Stock prices and profit margins are resting at all-time highs, prices to actual earnings are at nose bleed levels, and there could not be a better word than consensus to describe the sheer optimism toward U.S. stocks entering the new year.

10 out of 10 professionals polled by Barron's see stocks finishing 2015 at higher levels than they are today. As long as they are in full agreement no one will lose their job next year because "no one could have seen a stock market decline coming."

And the recent cover which needs no introduction: "This Time Is Different."

After selling out of eagles in November, the US Mint was still able to record an all time record in coins sold at 42.9 million this year (so far), topping the previous record of 42.7 million.

Coins are about 50% less expensive than they were through most of 2011, which continues to shock analysts who cannot understand why someone would want to own two coins for the price of one.

With the all-in cost hovering around $20 an ounce to pull physical silver out of the ground, insatiable physical appetite for the metal around the world and a steady stream of new industrial uses coming online every year it will be interesting to see how long silver can remain at these ridiculously low prices.

Wednesday, December 10, 2014

For the past two years the most hated assets on the planet have been gold and silver. With a modest sign of a pulse in precious metals over the past few weeks a new champion has emerged as the most despised asset in the world; oil.

The chart below from Sentiment Trader shows oil pessimism has now moved back to levels last seen following the Lehman crash when oil traded close to $30 a barrel.

Readers know I love to purchase assets when they are hated. If they become more hated, I love them more. Oil and oil related stocks have been on my shopping list for years, and I began purchasing again when the black gold hit $68 at the end of November. I plan on continuing to accumulate until it crosses back above $70 or until optimism returns. Hopefully that is years away.

Sunday, December 7, 2014

Star Capital has put together an excellent global heat map which provides a visual on the least to most expensive stock markets around the world based on the Shiller CAPE price to earnings ratio. Dark blue countries are the cheapest up through to the dark red countries which are the most expensive.

The United States is the second most expensive country in the world behind only Denmark, with a blistering 27.2 price to earnings ratio. The data is through the end of October and U.S. prices have moved higher since so the P/E ratio is even higher (more dangerous) today.

There are 10 countries in the world with P/E ratios under 10 (Greece, Russia, Hungary, Austria, Portugal, Italy, Ireland, and Brazil), which is historically considered the "cheap" entry point for a stock market (the U.S. was last there in the early 1980's). I am personally interested in select stocks within the Russian and Brazilian markets (see Jim Grant Is Still Bullish On Russian Stocks & Gold).

Can cheap markets get cheaper and expensive stocks get more expensive? Of course. That has certainly been the trend over the last few years. However, I personally believe purchasing an energy stock in Russia with decades of proven profits, high dividend payments and an enormous cash hoard at a P/E ratio of 2 is a safer long term bet than a U.S. technology company with a P/E ratio over 300, no profits and no dividends.

Please understand that, at this moment in market history, I am almost completely alone in this belief. The world today sees incredible value (and safety) within U.S. tech companies that are burning through millions of dollars of cash every month and only survive through steady capital raising which then re-values their company at higher and higher multiples. Following these insane capital raising events (perhaps shades of tulip bulb auctions centuries ago?) these start-ups find themselves with a paper valuation billions of dollars higher than a profitable Russian oil giant.

Again, this all seems strange to me, but I am a dinosaur in today's "new economy" where "this time is different," so I could not possibly understand how the world works.

Thursday, December 4, 2014

From late 2008 to early 2012 roughly one third of every mortgage holder in the United States was underwater (the mortgage on their home was higher than the price of their home). With home prices bottoming in early 2012, the number of underwater mortgages has steadily declined to under 8% today. The remaining 8% represent 4 million Americans which are underwater by an average of $39,000.

This is great news for many Americans who were formally trapped within their homes, but what is the long term cost the U.S. will endure to achieve this short term economic boost?

The government has become the mortgage market through Fannie Mae, Freddie Mac, FHA, etc. This has allowed new borrowers to continue borrowing with low down payments and sub-par credit and income levels. I understand conditions are tighter than they were in 2006, but they are far looser than where the free market would have set them following the 2008 crash.

The Federal Reserve entered the market in early 2009 and has been purchasing hundreds of billions of dollars worth of mortgages over the past five years. This pushed mortgage rates down to all-time record low yields; far below where the free market would have set interest rates on mortgages.

If these two actions were not taken home prices would have fallen much further; down to a level where the free market would feel comfortable lending to home owners based on their savings, income and credit criteria.

With home prices far lower a hypothetical new buyer entering the market today would only need to borrow $100,000 for a quality new home for their family, instead of perhaps the $300,000 that is actually needed. That extra $200,000 in debt could have been used over the next 30 years to save, re-invest in the economy, or purchase other goods (also growing the economy).

So where do we go from here?

It should be obvious with the government and Federal Reserve "all-in" there is only one direction we can go. If the government were to step away from the mortgage market in any capacity or if the Federal Reserve were to ever let mortgage rates rise again, home prices would immediately assume their downtrend. Even with full government support in place home prices are beginning to slow and even turn down in many areas.

Wednesday, December 3, 2014

The chart below provides an excellent visual on the four years of commodity pain. After out-performing the rest of the commodity space over the last two years, oil has "caught down" to the rest of the crowd. As readers know I've been a steady buyer of precious metals and agriculture over the last 18 months and following the recent carnage in the oil market I've become a buyer in that space as well.

In those three markets prices are low, sentiment is catastrophic and long term fundamentals are incredible. It doesn't happen often when you get all three to align as it did with Chinese stocks back in late 2012 (unfortunately the Chinese market is now about 37% higher and positive sentiment has returned).

Monday, December 1, 2014

"Meanwhile, the S&P 500 is more than double its historical valuation norms on reliable measures (with about 90% correlation with actual subsequent 10-year market returns), sentiment is lopsided, and we observe dispersion across market internals, along with widening credit spreads. These and similar considerations present a coherent pattern that has been informative in market cycles across a century of history – including the period since 2009. None of those considerations inform us that the U.S. stock market currently presents a desirable opportunity to accept risk.As was true at the 2000 and 2007 extremes, Wall Street is quite measurably out of its mind. There's clear evidence that valuations have little short-term impact provided that risk-aversion is in retreat (which can be read out of market internals and credit spreads, which are now going the wrong way). There's no evidence, however, that the historical relationship between valuations and longer-term returns has weakened at all. Yet somehow the awful completion of this cycle will be just as surprising as it was the last two times around – not to mention every other time in history that reliable valuation measures were similarly extreme. Honestly, you’ve all gone mad."

The Buffett indicator of stock market under/over valuation reached a new post 2009 high at 131% in November. The indicator measures the market cap of U.S. stocks to GDP. It is rapidly closing in on the mania peak reached in 2000. Will it get there before gravity returns?

U.S. stocks have now become 37% of total global market capitalization. Japanese stocks made up 42% of the global market in 1990 (the previous record) before they collapsed and fell for 23 years.

Here is the US stock market performance vs. the rest of the world. After 10 years of foreign stock out performance following the 2000 top, U.S. stocks have been outperforming the world by a wide margin since 2011. Will this data set mean revert again?

The amount of assets in the Rydex S&P 500 bullish fund is now double the amount in the bearish fund for the first time since February 2001. While investors have moved all in U.S. stocks betting long, everyone has given up betting against a decline. This becomes important as stocks put in their top because short sellers are needed to slow market declines (they lock in profits by buying back stocks they borrowed/sold on the way down which slows the market decline with their purchases). If there are no shorts, then the market has the ability to experience a waterfall decline.

Over the weekend Bitcoin passed the 1 year anniversary of its now famous top. At the end of November last year it crossed $1,240 and surpassed the price of one ounce of gold. There were countless projections during those frenetic November weeks about how Bitcoin would soon push toward $1 million.

One year later Bitcoin has collapsed down to $380, and almost no one talks about it anymore. To be honest, I'm surprised it is still that high. I would have preferred to purchase one ounce of gold when it was equal to Bitcoin at $1,240, but gold has also performed poorly over the last year, sitting at $1,200 as of this writing.

Investors have found a new found love in paper currency during 2014, specifically the U.S. dollar. My guess is that over the next five years one of the major paper currencies (perhaps the Japanese yen?) will experience the same time of plunge Bitcoin has endured over the last 12 months.

Saturday, November 29, 2014

Thursday, November 27, 2014

For the past few years I've discussed my "shopping list" of investments I track which I believe have strong long term fundamentals. I like to wait until assets on the list experience major price declines combined with low sentiment levels before making a purchase. Oil has been on the list for the past few years, but I've consistently felt the price and sentiment surrounding it were too high for me to step in and make a purchase.

That has changed.

This morning OPEC announced they would not be cutting production in the months ahead and oil is currently in free fall, down close to 7% on the day at $68 a barrel. Oil is now down 33% from where it was it late June (over $100 a barrel).

Wall Street was thoroughly bullish on oil in June after prices had risen steadily throughout early 2014. Articles discussed why higher prices were imminent due to Russia, geopolitical tensions, and global growth.

Today we read everywhere there is no floor for the price. The discussion is centered around how low oil will eventually fall and the new trading range it will move within over the next five years (estimates range between $30 to $70). The bulls, of course, have completely disappeared.

I'll be a buyer of oil and oil related energy stocks moving forward until it begins to move higher and positive sentiment returns. Will the price fall lower from here? Almost assuredly. I look forward to the panic sales in the strongest companies.

Oil related assets will be added to a buying list that currently includes precious metals, uranium stocks, agriculture, and emerging market bonds. These are light positions as I continue to heavily add cash (U.S. dollars) in anticipation of larger sell-offs coming in other attractive but overpriced markets. I am not making an investment recommendation to anyone, but readers of the site often ask me what I am purchasing today.

Grant has 26 years of experience in finance on the Asian, Australian, European and US markets and has held senior positions at several international investment houses.

In the presentation below, Grant walks through history finding parallels to periods of easy credit and consequences of those actions. For the text summary and charts included in the topic above (click bottom right box for full screen):

Sunday, November 23, 2014

The most recent U.S. foreign debt holdings were released this week (data through August 2014) showing countries outside the United States now hold a record $6.07 trillion in U.S. treasury debt.

China and Japan remain the largest holders with Belgium growing fast (many assume Belgium is used by China as a remote buying station).

Most of the debt issued by China and Japan is held within their own borders by institutions and individual investors. Understanding where the debt is held will become important as we approach the next stage of the sovereign debt crisis.

For example, while both the United States and Japan will continue to "pay down" their debts through depreciation (central banks purchasing the debt with printed money), when push comes to shove it is far more likely the U.S. government will require foreign bond holders to take a "haircut" on their debt holdings (remember the Greek haircut?). Japan, on the other hand, would only bankrupt its financial system and decimate the retirement accounts of individual citizens with such a haircut.

When it comes to the breaking point, politicians will always do what will keep them in office for just one more voting term, which will be to push back the pain for those casting votes as long as possible. While this type of discussion is most likely further down the road for the United States, the Japanese currency and bond markets can collapse at any moment.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.